U.S. debt downgrade – Does it matter?

DEWITT, Mich. - Aug. 8, 2023 - PRLog --

• Fitch downgraded U.S. government credit, shining a spotlight on the growing federal debt burden. Yet, the decision does not impact the fundamental drivers of the economy and markets.
• Bonds are once again under pressure but could rally into 2024 as the end of Fed tightening becomes clear.
• The July jobs report provided mixed takeaways. The labor market is cooling but only slowly. Wage growth remains a concern.
• We think the evolution of growth and inflation provides a solid foundation for stocks to remain in a sustainable uptrend, though with more volatility in the second half of the year.

August started with a bang, as the market's summer calm was disrupted by news that Fitch, one of the "Big Three" credit agencies, downgraded the U.S. debt rating from AAA to AA+. This is the second credit downgrade in U.S. history after a similar decision by Standard & Poor's in August of 2011. U.S. political brinkmanship and debt concerns are not new, but the Fitch downgrade shines the spotlight on the worsening fiscal outlook.

Stocks experienced their first 1% down day since May, and the 10-year Treasury yield rose to a fresh high for the year, flirting with last year's cycle peak of 4.25%¹. Are last week's developments significant enough to alter the outlook for the markets, and what's the message that bonds are sending?

The 2011 experience and how it differs from today

When the U.S. lost its AAA rating from Standard & Poor's more than a decade ago, a decision that has not yet reversed, it triggered a 4.8% decline in the S&P 500 the day of the announcement on August 4 and another 6.5% decline on August 8¹. Stocks remained volatile over the following two months. But counterintuitively, investors gravitated toward government bonds and the U.S. dollar as safe havens against the uncertain backdrop.

Last week's stock-market reaction to the Fitch downgrade was more muted, which we think is justified. Besides investors having now gone through a similar event for which there was no precedent in 2011, there are some stark differences in the economic landscape. Heading into another standoff over the debt limit and S&P's downgrade in 2011, investor sentiment was fragile, with the memories of the Global Financial Crisis (GFC) fresh, economic growth anemic, unemployment elevated at 9%, and credit spreads wide. In contrast today, the economy has been growing at an above-trend pace over the past four quarters, the unemployment rate at 3.5% is near historic lows, and credit spreads are narrow.

Source: 1. Bloomberg